Outsourcing and Financing Decisions in Industry Equilibrium

In a competitive product market, firms that buy their input have lower profit volatility than they would have if they were to make it. This effect on profit volatility is an important consideration in the firms' capital structure choices and their make or buy decisions when it interacts with the risk-taking incentive of equityholders of levered firms. Even with a cost advantage enjoyed by a supplier and passed on to its customers, in an industry equilibrium of a priori identical firms, only those that use little or no debt outsource their input to the supplier; all significantly debt-financed firms produce their own input and take advantage of the greater profit volatility resulting from internal production.